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International
The Subsidiary as a Permanent Establishment
In this article, the authors summarize the
discussion on the topic of the subsidiary as a
permanent establishment, which was
considered by Seminar A of the 64th Congress of
the International Fiscal Association, held in
Rome, Italy on 30 August 2010.
1. Introduction
At the 2010 International Fiscal Association (IFA)
annual congress held in Rome, Italy, from 29 August to 3
September, the subject of Seminar A (the Seminar) was
The subsidiary as a permanent establishment.1 In this
respect, the following four international tax law cases
were considered: (1) Zimmer 2 (France); InverWorld 3
(United States); Rolls Royce4 (India); and Philip Morris5
(Italy).
2. The Subsidiary as a Permanent Establishment
in the OECD Model
When an enterprise of a contracting state carries on busi-
ness in another contracting state, the following two ques-
tions must be asked before the second state can levy tax on
the profits of the enterprise: (1) whether or not the enter-
prise has a permanent establishment (PE) in this state; and
(2), if the answer to question (1) is affirmative, what, if any,
the profits are on which the PE should pay tax.6
A PE is, however, not always easy to identify. This is par-
ticularly true where a PE is hidden behind a dependent
operating company, i.e. if an operating company in addi-
tion to its own business also carries on another com-
panys business as a PE of the latter. In this regard, the
2010 OECD Model Tax Convention (the OECD
Model) states in Art. 5(7) that:
[t]he fact that a company which is a resident of a Contracting
State controls or is controlled by a company which is a resident
of the other Contracting State, or which carries on business in
that other state (whether through a permanent establishment or
otherwise), shall not of itself constitute either company a perma-
nent establishment of the other (emphasis added)
This follows from the principle that, for the purpose of
taxation, such a subsidiary constitutes an independent
legal entity.7 Accordingly, both companies are subject to
unlimited tax liability in the state in which they are resi-
dent or where their place of management is located.
However, by using the wording not of itself , the provi-
sion clarifies that a parent company (parent) can have an
(agent) PE in its subsidiarys state of residence if the gen-
eral requirements for a PE set out in Art. 5(1) to (5) of the
OECD Model are met. Accordingly, any space or prem-
ises belonging to the subsidiary that is at the disposal of
the parent (the right-to-use test) and that constitutes a
fixed place of business (the location test and the dura-
IBFD
Lus Eduardo Schoueri*
and Oliver-Christoph Gnther**
tion test) through which the parent carries on its own
business (the business activity test), gives rise to a PE of
the parent under Art. 5(1), subject to Art. 5(3) and (4), of
the OECD Model.8 In addition, under Art. 5(5) of the
OECD Model, a subsidiary constitutes an agency PE of
its parent if the subsidiary has the authority to conclude
contracts in the name of its parent and habitually exer-
cises this authority, unless these activities are limited to
those referred to in Art. 5(4) or unless the subsidiary
does not act in the ordinary course of its business as an
independent agent within the meaning of Art. 5(6). Sev-
eral examples of controversial arrangements with poten-
tial PE exposure may be noted, such as stripped distribu-
tors or commissionaires, personnel of the parent
seconded to its subsidiary, supervision of toll manufac-
turing arrangements, managers shared with the parent,
and subsidiary and partnership or joint-venture
arrangements.
3. Zimmer
One recently decided international tax law case on the
issue of the subsidiary as a PE is the French case of Zim-
mer.9 Specifically, on 31 March 2010, the French
Supreme Administrative Court (Conseil dtat) held that
* Chair of Tax Law, Department of Economic and Financial Law, Law
School, So Paulo University, Professor, Mackenzie University, So
Paulo, and Partner, Lacaz Martins, Halembeck, Pereira Neto, Gure-
vich & Schoueri Advogados. The author can be contacted at
schoueri@lacazmartins.com.br.
** Mag and LLB, and research and teaching associate, Institute for Aus-
trian and International Tax Law, WU (Vienna University of Econom-
ics and Business). The author can be contacted at Oliver-
Christoph.Guenther@wu.ac.at.
1. The panel members consisted of Paolo Valerio Barbantini (Italy, Chief,
Large Business Division, Italian Revenue Agency), Dr Xaver Ditz (Ger-
many, Partner Flick Gocke Schaumburg), Steven P. Hannes (United States,
Partner in McDermott Will & Energy LLP), Anita Kapur (India, Chief
Commissioner of Income Tax, Indian Revenue Agency) and Michael
Lennard (Chief, International Tax Cooperation and Trade, UN Financing
for Development Office). Seminar A was chaired by Lus Eduardo
Schoueri (Brazil) with the help of Oliver-Christoph Gnther (Austria) as
Panel Secretary.
2. Supreme Administrative Court, 31 March 2010, Socit Zimmer Limited v.
Ministre de lconomie, des Finances et de lIndustrie, Nos. 304715 and
308525.
3. US Tax Court, 12 May 1997, InverWorld Inc. et al. v. Commissioner, T.C.
Memo 1997-226 (1997).
4. Delhi Income Tax Appellate Tribunal, 26 October 2007, Rolls Royce Plc v.
Deputy Director of Income Tax, ITAT Nos. 1496 to 1501/DEL of 2007.
5. Supreme Court, 7 March 2002, Philip Morris, Nos. 3667, 3368, 7682 and
1095.
6. Para. 1 of the Commentary on Art. 5 of the OECD Model.
7. Para. 40 of the Commentary on Art. 5 of the OECD Model.
8. Para. 41 of the Commentary on Art. 5 of the OECD Model; M. Grl,Art.
5, in K. Vogel et al. (eds.), Klaus Vogel on Double Taxation Conventions
(London: Kluwer Law International, 1997), m.no. 192; and M. Lang, Intro-
duction to the Law of Double Taxation Conventions (Amsterdam: IBFD,
2010), m.no. 248 et seq.
9. Zimmer, supra note 2.
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Lus Eduardo Schoueri and Oliver-Christoph Gnther
a French commissionaire does not constitute a PE for its
foreign parent under the 1968 FranceUnited Kingdom
tax treaty.10
The facts of the case were that Zimmer SAS, a French
commissionaire, sold products in France under a civil
law commercial arrangement in its own name, but on the
account of, and at the risk of, its UK parent (Zimmer
Limited). With regard to the French customers, Zimmer
Limited was an undisclosed principal. Before the com-
missionaire agreement was signed, Zimmer SAS had
only been a French distributor of the products sold by
Zimmer Limited.
The French tax authorities were of the opinion that Zim-
mer Limited had a PE in France and also that, whilst act-
ing as a commissionaire, Zimmer SAS was a dependent
agent with the power to bind its UK parent in respect of
commercial transactions relating to the latters own
activities. Accordingly, Zimmer Limited was deemed to
be liable to tax in France. The taxpayer challenged the
relevant assessment before the Administrative Court of
Appeals of Paris (Cour Administrative dAppel de Paris).11
The Administrative Court of Appeals rejected the
claim.12
The Supreme Administrative Court, however, disagreed
with the Administrative Court of Appeals. The findings
of the Supreme Administrative Court were based on the
examination of French commercial law. In particular, the
Supreme Administrative Court stated that, even though
Zimmer SASs contracts with customers were concluded
on account of Zimmer Limited, they did not bind the lat-
ter with regard to the customers. Under commercial law,
for the commissionaire to bind its supplier, either the
contract of commission or other factual elements relat-
ing to appointment must make the principal personally
bound by contracts concluded by commissionaire with
its customers.
It should be noted that the Supreme Administrative
Court only considered French private law. This approach
prevailed over the economic approach of the Adminis-
trative Court of Appeals and the tax authorities, which
was based on a purely factual analysis of the condition
regarding the authority to bind.
On the other hand, in its ruling, the Supreme Adminis-
trative Court admitted the possibility for the tax author-
ities to requalify the commissionaire agreement if it
appeared that the commissionaire legally bound its
principal. According to the Supreme Administrative
Court:
contracts concluded by a commissionaire, even though they are
concluded for the account of its principal, do not bind the latter
directly vis--vis the counterparties of the commissionaire. It
follows, that a commissionaire cannot in principle constitute a
permanent establishment of the principal, solely because in exe-
cution of its contract of commission it sells while signing con-
tracts in its own name products or services of the principal for
the latters account.13
Zimmer is, therefore, a case in which a PE was not recog-
nized due to the (formal) civil law peculiarities of the
70 BULLETIN FOR INTERNATIONAL TAXATION FEBRUARY 2011
Pagina 70
case. The case reveals that a subsidiary could be deemed
to be a PE, but only if it could legally bind its principal.
4. InverWorld and the 2009 IRS Interpretation
In InverWorld,14 the US Tax Court examined in detail
contractual rights and obligations of a US subsidiary
(USCO) of a Cayman Islands affiliate (CICO). Both of
these companies were owned by InverWorld Mexico
(IW Mexico). IW Mexico had established CICO to pro-
vide Mexican investors with access to non-Mexican
financial markets, in particular the United States. USCO
was set up to receive investment instructions from
clients, to make such investments and to maintain a
record of actions. USCO invested funds that were held
by USCO through CICO by purchasing and selling debt
instruments and securities. USCO also opened, main-
tained and closed accounts with any broker, dealer or
investment concern at which CICO maintained
accounts for Mexican investors. The consulting agree-
ment between USCO and CICO allowed USCO to
engage in these activities. The agreement also specified
that USCO was for all purposes an independent con-
tractor and not an agent or employee of CICO and shall
have no authority to act for, represent, bind or obligate
CICO.
The US Tax Court concluded that the provisions author-
izing specific agent-type activities were exceptions to the
contracts general agency prohibition. USCO had, and
exercised, specific rights to enter into and conclude con-
tracts and, therefore, acted on behalf of CICO. Accord-
ingly, USCO was the agent of CICO and USCOs US
office was to be treated as the US office of CICO and,
therefore, subject to US income tax.
InverWorld is the subject of a controversial 2009 inter-
pretation by the Internal Revenue Service (IRS).15 The
decision is based only on US internal law, as the case
involves taxable years in which no tax treaty in respect of
taxes on income were in force either with the Cayman
Islands or with Mexico. However, the IRS has argued in a
recent legal advice memorandum that internal law prin-
ciples would apply in a US PE analysis under a US tax
treaty. This relies in part on InverWorld and states that a
foreign corporation has a US trade or business because
of the activities of a US corporation, even though latter
does not enter into contracts in the name of a foreign
corporation. The IRS did not argue that, in fact or in sub-
10. For further details, see B. Gouthire, Zimmer: Commissionaire Agent Is
Not a Permanent Establishment, European Taxation 8 (2010), p. 350 et
seq. and S. Gelin and D. Gutmann, France: Commissionaire as PE?, Tax
Planning International, European Union Focus (2010), Vol. 12, No. 4, p. 10
et seq.
11. Administrative Court of Appeals of Paris, 2 February 2007, Socit Zim-
mer Limited, No. 05-2361.
12. S. Gelin and D. Sorel,French Commissionaire: A PE for Its Foreign Prin-
cipal, Tax Notes International (6 August 2007), p. 581 et seq.
13. Socit Zimmer Ltd v. Ministre de lconomie, des Finances et de lIndustrie,
International Tax Law Reports 12 ITLR 739 (772) (2010).
14. InverWorld, supra note 3.
15. IRS Generic Legal Advice Memorandum (GLAM): Lending in the United
States by Foreign Person Giving Rise to Effectively Connected Income
(22 September 2009), AM2009-010.
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stance, a US corporation made commitments on behalf
of a foreign affiliate. The opinion of Steven P. Hannes in
the Seminar was that the IRS had misinterpreted Inver-
World in an attempt to expand US net source basis taxa-
tion by characterizing a US person as an agent of a for-
eign person and viewing such activities as creating a US
trade or business.
5. Rolls Royce
Another important international tax law case concern-
ing subsidiaries as PEs is the Indian case of Rolls Royce.16
Rolls Royce plc (RR) was incorporated and, therefore,
liable to tax in the United Kingdom without limit. RR
supplied aero-engines and spare parts to customers in
India and wholly owned a UK-incorporated subsidiary,
Rolls Royce India Limited (RRIL), which had offices in
India. RRIL entered into an agreement with RR to pro-
vide certain support services to RR on a cost-plus basis.
The Indian tax authorities were of the opinion that RR
had a PE in India due to the offices of its UK subsidiary.
On appeal, the Commissioner of Income Tax confirmed
the view of the tax authorities and the matter was
appealed further to the Delhi Income Tax Appellate Tri-
bunal (ITAT).
The ITAT took the position that the premises in India,
which were ostensibly occupied by RRIL, were main-
tained and used by RR for its business. RRs employees
visited India frequently and occupied and used these
premises. Activities conducted from these premises
formed an essential and significant part of the activity of
RR. Some of RRs employees present in various locations
in India reported to the director of RRIL. RRIL operated
like a marketing office in receiving orders and undertook
activities that converted a request for quotations into
orders. Some senior employees of RRIL, including the
Marketing Director, were functionally responsible to RR.
The employees of RRIL participated in business meet-
ings of RR with clients with authority to take decisions in
such meetings. All requests for quotations or time exten-
sions were routed through RRIL so that only the corre-
spondence setting out standards was forwarded. The
employees of RRIL commented on contract clauses,
delivery schedules and payment timetable. The employ-
ees also analysed proposals, sought clarifications from
the customers and had a significant role in the sale of
products in India. In addition, the employees had the
authority to sign documents on behalf of RR and gave
certificates binding on the part of RR (for example, they
issued certificates under the Foreign Corrupt Practices
Act, certificates of origin of goods manufactured and
warranty statements on behalf of RR). RRIL was totally
dependent on RR and operated wholly and exclusively
for RR and habitually secured orders exclusively for RR.
Accordingly, RRIL was deemed to be a customer facing
business unit of RR. The activities of the fixed place
were considered to be the core activities of marketing,
negotiating and selling products, and were not of a
preparatory or auxiliary character. For all these reasons,
the ITAT stated that Art. 5 of the 1993 IndiaUnited
Kingdom tax treaty, which differs significantly from the
IBFD
The Subsidiary as a Permanent Establishment
OECD Model, should apply. Consequently, the UK sub-
sidiary had created by way of its offices in India an
agency PE for its UK parent.17
The case reveals that the Indian courts tend to adopt a
very broad PE approach. Specifically, the ITAT held that
RRIL constituted a fixed place as well as an agency PE of
RR, as RRIL also habitually secured orders wholly exclu-
sively for RR. However, RRIL did not have the legal
authority to negotiate and enter into contracts on behalf
of RR. As a result, RR was not bound if RRIL secured
orders. This interpretation is not in line with the interna-
tional standard, which focuses on the legal aspects.
Accordingly, it is difficult for international companies to
know whether or not their business activities constitute
an Indian PE. The decision may also cause such
companies to remove global support services from
India.18
6. Philip Morris
Another very important case that raised wide-ranging
debate regarding its consistency with international tax
law in the scientific tax community is the noted Italian
case of Philip Morris.19 Philip Morris is not a recent case,
but due to its importance with regard to discussion of
the extension of PEs to subsidiaries, its peculiarities were
considered in the Seminar.
The Italian Tobacco Administration paid royalties to
companies that were members of the Philip Morris
group in respect of the licence to manufacture and dis-
tribute cigarettes with the Philip Morris trademark in
Italy. Intertaba Spa, a Philip Morris group member,
which had the manufacture and distribution of cigarette
filters in Italy and abroad as its main business purpose,
supervised the execution of the contract with the Italian
Tobacco Administration. According to the Italian tax
authorities, the activities of Intertaba Spa created a dis-
guised PE in Italy in respect of other Philip Morris
group members. The evidence for such a conclusion
included participation of Intertaba Spa in the negotia-
tion of the licence contract, the carrying-out of a number
of activities (falling outside of the corporate purpose of
Intertaba Spa) for the sole interest of foreign companies
and incurring costs without compensation. Conse-
quently, according to the tax authorities, the royalties
derived by the Philip Morris group members from the
Italian Tobacco Administration were subject to tax in
Italy. Intertaba Spa appealed to the competent tax court.
The Italian Courts of First and Second Instance (the
Provincial Tax Court of Milan, Commissione Tributaria
16. Rolls Royce, supra note 4.
17. For further details, S. Kapoor, Rolls Royce Decision: Income Attribution
to Permanent Establishments, International Transfer Pricing Journal 3
(2008), p. 141 et seq.; S. Sharma, Attribution to Profits to Permanent
Establishments The Indian Experience, Asia-Pacific Tax Bulletin 2
(2008), p. 93 et seq.; and S. Goradia and S. Kapila, India, in J. Sasseville
and A.A. Skaar (eds.), Is there a permanent establishment?, Cahiers de
droit fiscal international (The Hague: Sdu Uitgevers, 2009), p. 345 et seq.
18. Kapoor, supra note 17, Sec. 4.
19. Philip Morris, supra note 5.
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Lus Eduardo Schoueri and Oliver-Christoph Gnther
Provinciale di Milano,20 and the Regional Tax Court of
Milan, Commissione Tributaria Regionale di Milano)21
found in favour of the taxpayer, as the tax authorities had
failed to prove that the Philip Morris group members
had the physical space available in Italy through which
their business could be carried on and that Intertaba Spa
was a dependent agent of the Philip Morris group
companies in participating in and concluding agree-
ments with the Italian Tobacco Administration. The tax
authorities appealed to the Italian Supreme Court (Corte
Suprema di Cassazione), which held in favour of the tax
authorities. The case was remitted to another section of
the Court of Second Instance and the following five
principles were established by the Supreme Court that
were to be taken into account in deciding the case:
(1) an Italian resident company may take the role of a
multiple PE of foreign companies belonging to the
same group and pursuing a common plan;
(2) the supervision or control of the performance of a
contract cannot, in principle, be considered to be
auxiliary activities within the meaning of Art. 5(4) of
the OECD Model;
(3) the participation of representatives or employees of
a resident company in a phase of the conclusion of a
contract between a foreign company and another
resident entity may fall within the concept of author-
ity to conclude contracts in the name of the foreign
company, even in the absence of a formal power of
representation;
(4) if an Italian company is entrusted with the manage-
ment of business transactions of a non-resident
company, such an activity may constitute a PE; and
(5) the fulfilment of the conditions for a PE must be ver-
ified using a substantive, as opposed to a formalistic,
approach (authors unofficial translation).
The case was settled by the taxpayer and no final deci-
sion was issued by the Court of Second Instance. Never-
theless, the case raised intense international debate and,
in reaction to the decision and the subsequent discus-
sion at the international level, the OECD clarified in the
2005 OECD Model that the principles in Art. 5(7) apply
to any company forming part of a multinational group.
However, the determination of the existence of a PE
must be carried out separately for each company of the
group and not the group as a whole.22 In addition, no PE
exists when a company that is a member of a multina-
tional group provides services to another group com-
pany as part of its own business carried on in premises
that are not those of that other company and using its
own personnel.23 The fact that a person has attended or
even participated in negotiations in a state between an
enterprise and a client is, in itself, insufficient to con-
clude that the person has exercised in that state an
authority to conclude contracts in the name of the enter-
prise.24 Italy, in reaction, made an observation in respect
of these updates in the Commentary on the 2005 OECD
Model.25 The observation was inserted to clarify that
Italian jurisprudence should prevail over the OECD
interpretation.26
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Pagina 72
7. Subsidiary as a PE in the UN Model
Art. 5 of the 2001 UN Model Tax Convention (the UN
Model) differs significantly from its counterpart in the
OECD Model in various ways, i.e.:
The scope of Art. 5(3)(a) of the UN Model addition-
ally includes assembly projects and supervisory
activities in connection with building sites or con-
struction, installation or assembly projects. The
required PE duration is also reduced from twelve to
six months.
The UN Model includes a special PE provision for
services (Art. 5(3)(b)). Accordingly, an enterprise is
deemed to have a PE in the other contracting state as
a result of the performance of services exceeding a
period or periods of more than six months in aggre-
gate in any twelve-month period.27
Art. 5(4) of the UN Model is narrower than its coun-
terpart in the OECD Model, as facilities used solely
for the purpose of delivery and stock maintained
only for the purpose of delivery are not referred to.
According to Art. 5(5)(b) of the UN Model, the
actions of a dependent agent may constitute a PE,
even without having and habitually exercising the
authority to conclude contracts in the name of the
enterprise, where that person habitually maintains a
stock of goods or merchandise and regularly makes
deliveries from the stock.
The UN Model includes an additional provision on
the PEs of insurance companies (Art. 5(6)).
In contrast to Art. 5(6) of the OECD Model, the
corresponding provision in the UN Model (Art.
5(7)) specifies that an agent is not considered to be
an agent of independent status if the activities are
devoted wholly or almost wholly on behalf of one
enterprise and non-arms length conditions are made
or imposed between the agent and the principal.
Art. 5(8) of the UN Model has the same wording as
Art. 5(7) of the OECD Model. However, the Commen-
tary on the UN Model cites the Commentary on the
2000 OECD Model the applicable OECD Model when
20. Provincial Tax Court of Milan, 12 September 1997, Philip Morris, No.
238.
21. Regional Tax Court of Milan, 24 March 2000,Philip Morris, No. 313/99.
22. Para. 41.1 of the Commentary on Art. 5 of the OECD Model.
23. Para. 42 of the Commentary on Art. 5 of the OECD Model.
24. Para. 33 of the Commentary on Art. 5 of the OECD Model.
25. Para. 45.10 of the Commentary on Art. 5 of the OECD Model. For further
details, see R. Russo and E. Pedrazzini, Permanent Establishments under
Italian Tax Law: An Overview, European Taxation 8/9 (2007), p. 389 et
seq.; C. Romano and R. Russo, Italian Tax Consequences of Permanent
Establishments, Bulletin for International Taxation 8/9 (2010), p. 456 et
seq.; M. Gazzo,Permanent Establishment through Related Corporations:
New Case Law in Italy and its Impact on Multinational Flows, Bulletin for
International Fiscal Documentation 6 (2003), p. 257 et seq.; and L. Favi,
Italy, in Sasseville and Skaar, supra note 17, p. 393 et seq.
26. C. Innamorato, The Concept of a Permanent Establishment within a
Group of Multinational Enterprises, European Taxation 2 (2008), p. 81 et
seq.
27. See also Para. 42.23 of the Commentary on Art. 5 of the OECD Model.
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the UN Model was effectively finalized. Accordingly,
changes made to the Commentary on the 2000 OECD
Model (for example, after Philip Morris) are not included
in the Commentary on the UN Model. The proposed
Commentary on the 2011 UN Model will follow the
Commentary on the 2008 OECD Model, i.e. post-Philip
Morris. However, the text regarding Art. 5(8) of the UN
Model is preceded by the words [t]his paragraph repro-
duces article 5(7) of the OECD Model. The Commentary
on the OECD text is as follows:.... In the view of the Sem-
inar panel members, it is questionable if this is an
endorsement by implication.
In addition, according to Michael Lennards information
as provided in the Seminar, the UN Committee plans to
make the following comment between Paras. 41.1 and 42
of the Commentary on Art. 7 of the OECD Model:
The Committee notes that determining on a separate entity basis
whether or not a permanent establishment exists may be vulner-
able to abusive arrangements. Depending on the domestic law of
States, safeguards against purely artificial structures may be
found in applying a rule that substance overrides form. The
Commentary of the OECD Model also states the following: [the
Commentary on Art. 7 of the 2011 UN Model will then quote
Para. 42 of the Commentary on Art. 7 of the OECD Model]
During the Seminar, questions were raised that revealed
that the treatment of a subsidiary as a PE is not clear. For
instance, it should be decided as to whether this
approach differs according to the extent to which legal
form can be disregarded, as in the Commentary on the
OECD Model, or whether this just states the obvious.
The reference to, and/or relevance of, a background of
group policies that are intended to convert manufactur-
ing or marketing subsidiaries into toll manufacturers or
agents, with the subsequent risk and profit shifting, also
require further discussion.
8. Attribution of Profits to a Subsidiary
Considered to Be a PE in the OECD and UN
Models
Once it is accepted that a subsidiary may be considered
to be a PE of its parent, the next problem to solve is how
to attribute profits to this subsidiary. A subsidiary usu-
ally has its own activities and if these activities are per-
formed on an arms length basis, profits must be attrib-
uted to the subsidiary according to transfer pricing rules.
When the subsidiary is deemed to be a PE of its parent, it
is also necessary to consider that the parents profits (if
any), when attributed to the PE, are subject to tax.
Accordingly, two different amounts must be considered
for the purposes of taxation, i.e. the subsidiarys profits
and the PEs profits. The Seminar only examined the lat-
ter.
In this regard, the following two levels of legislation must
be taken into account: (1) treaty law; and (2) national law.
As there had been considerable variation in the interpre-
tation of the attribution of profits, the OECD undertook
work on the Report on the Attribution of Profits to Per-
manent Establishments (the Report).28 The Report
considers the functionally separate entity approach to
be the guiding principle. Under the authorized OECD
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The Subsidiary as a Permanent Establishment
approach (AOA), a functional analysis must be carried
out before the arms length principle can be applied to
internal dealings between a headquarters and its PE.29
In a first step, the significant people functions per-
formed, the risks assumed and the assets employed are
analysed in respect of attributing profits to the PE.30 In
principle, the more functions a PE performs and the
more risks it assumes, the greater its profits should be.
The international dealings between the PE and the other
parts of the enterprise must also be identified, analysed
and documented, especially those relating to its head-
quarters. In addition, capital must be attributed to the PE
in line with the assets and risks allocated to it.
In a second step the internal dealings must be valued on
the basis of the arms length principle. The OECD Trans-
fer Pricing Guidelines(theGuidelines)31 that have been
developed for transactions between associated enter-
prises should be also applied by analogy for the purpose
of Art. 7 of the OECD Model. As a result, the principles
and transfer pricing methods set out in the Guidelines
also apply to determine the PEs profit. A global profit
split is not feasible. In this regard, the AOA was fully
implemented in the 2010 OECD Model.32
National tax law then regulates on how to determine the
taxable income of a PE in general. Among others, it
defines the realization of profits (for instance, the trans-
fer of an asset to a foreign PE entails the realization of
profits and tax-deductible expenses) and may set out
indirect methods of determining the amount of the PEs
profits.
The general rule in Art. 7(1) of the 2010 OECD Model
that a state may only tax profits attributable to the PE is
slightly amended in the UN Model. Specifically, Art.
7(1)(b) and (c) of the UN Model provides for the limited
force-of-attraction principle, which permits the enter-
prise, once it carries out business through a PE in the
source state, to be taxed on business profits in that state
that arise from transactions of the same or similar kind
outside the PE.33 The UN Tax Committee currently does
not intend to adopt the OECD standard in the planned
2011 UN Model. In this respect, the new OECD
approach was considered to be too complicated and,
therefore, not administrable for the tax authorities in
developing countries. Such an approach could also limit
the taxation rights of source states in an undesirable way,
again from the perspective of developing countries.34
28. OECD, Report on the Attribution of Profits to Permanent Establish-
ments (Paris: 2010).
29. Lang, supra note 8, m.no. 263.
30. D. Oosterhoff, The True Importance of Significant People Functions,
International Transfer Pricing Journal 2 (2008), p. 68 et seq.
31. OECD, Transfer Pricing Guidelines for Multinational Enterprises and
Tax Administrations (Paris: 2010).
32. Lang, supra note 8, m.no. 264 and J. Malherbe and P. Daenen,Permanent
Establishments Claim Their Share of Profits: Does the Taxman Agree?,
Bulletin for International Taxation 7 (2010), p. 359.
33. Lang, supra note 8, m.no. 245 and A. Hemmelrath, Art. 7, in Vogel, supra
note 8, m.no. 35.
34. UN Committee of experts on international cooperation in tax matters
holds sixth meeting in Geneva, Tax News Service (27 October 2010).
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bit_2011_02_article_02.qxp:bit_2011_02 10-01-2011 14:54 Pagina 74

Lus Eduardo Schoueri and Oliver-Christoph Gnther

9. Cases Revisited in India were not wholly replaced by the agent in India,
the agent did not, therefore, extinguish the tax liability of
In cases where it is decided that no PE exists, naturally
RR. On the basis of these facts, the ITAT held that
the courts do not provide any indications regarding the
domestic law had to be applied to determine the profits
way in which profits should be allocated to a PE. Accord-
attributable to the marketing activities. As a result, 35%
ingly, for example, no indication regarding this question
of the global profits in respect of sales made in India
can be found in Zimmer. In Philip Morris, there is also no
were chargeable to tax in India.
indication in this regard, as the case was settled by the
taxpayer. Consequently, the Italian Court of Second
Instance (to which the Italian Supreme Court had remit- 10. Conclusions
ted the case) could not issue a final decision. However,
The PE concept in international tax law has been
assuming the existence of a PE in Italy, the primary issue
used for many years for the taxation of a taxpayers
to be determined would have been the royalties. In Philip
business activities in other states. However, when
Morris, the questions would have been which significant
defining if a subsidiary has a PE in another state and
people functions could be identified and who actually
how much profit, if any, is attributable to this PE, the
carried them out.35
decisions of courts from around the world reveal that
In Rolls Royce, the ITAT stated that manufacturing and the concept is interpreted in many different ways.
research and development activities outside India and The Seminar at the 2010 IFA Annual Congress
marketing activities were carried out by RRIL as a PE of illustrated this fact in its discussion of four relevant
RR in India. RRILs activities went beyond the support international tax law cases.
services noted in the agreement. The agents remunera-
tion did not represent the value of profit attributable to
all of the activities of RR in India. As the activities of RR 35. Oosterhoff, supra note 30.

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